Macro Session 10

7/24/2019 Macro Session 10

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Macroeconomic Analysis and Policy

Macroeconomic Analysis andPolicy

Income-Expenditure Model

Session:10Prof. Biswa

Swarup

Misra

Dean, XIMB


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Discussion Points

1. Equilibrium Income

2. Consumption Function

3. Multiplier

4. Fiscal Policy

5. Limitations of Fiscal Policy


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The Income-Expenditure Model

The income-expenditure model was originally

developed by the economist John MaynardKeynes in the 1930s and later extended andrefined by many economists.

The model is based on the idea that higher

expenditures are necessary to generate higherlevels of income in the economy.

The model is useful for understanding

economic fluctuations in the very short-runwhen prices do not change very much.


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aggregate output: The total quantity of goods and services produced (orsupplied) in an economy in a given period.

aggregate income: The total income received by all factors of productionin a given period.

In any given period, there is an exact equality between aggregate output

(production) and aggregate income. You should be reminded of this factwhenever you encounter the combined term aggregate output (income)(Y).

aggregate output (income) (Y) A combined term used to remind you ofthe exact equality between aggregate output and aggregate income.

Also, we are taking as fixed for purposes of current discussion theinterest rate (r) and the overall price level (P).

The Income-Expenditure Model


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A Simple Income-Expenditure Model

At any point on the 45Eline, the distance to thehorizontal axis is the sameas the distance to the

vertical axis.


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Adjustment to Equilibrium Output

If output were higher (y1), it

would exceed demand and

production would fall.

If output were lower (y2), it

would fall short of demandand production would rise.

Table 11.1 Adjustments to Equilibrium Output

C + I Production Inventories Direction of Output

100 80 Depletion of inventories of 20 Output increases

100 120 Excess of inventories of 20 Output decreases

100 100 No change Output stays constant


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We all recognize that for consumption as a whole, as well as

for consumption of most specific categories of goods andservices, consumption rises with income.

While Keynes recognized that many factors, including wealthand interest rates, play a role in determining consumptionlevels in the economy, in his classic The General Theory of

Employment, Interest, and Money, current income played thekey role.

This simple observation plays a large role in helping usunderstand the workings of the aggregate economy.

The Keynesian Theory of Consumption


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consumption function: The relationship between consumption and

income.

A Consumption Function for aHousehold

A consumption functionfor an individual

household shows thelevel of consumption ateach level of householdincome.



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To explain aggregate spending behavior, economists

speculate that an increase in aggregate income in a givenperiod will result in an increase in aggregate consumption inall of the following instances, except:a. When household wealth increases.b. When interest rates rise.c. When households form positive expectations about the

future.d. None of the above. In all of the cases above, aggregate

consumption will rise.



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With a straight line consumption curve, we can use the followingequation to describe the curve:

An Aggregate ConsumptionFunction

The aggregate consumptionfunction shows the level of

aggregate consumption ateach level of aggregateincome.The upward slope indicatesthat higher levels of incomelead to higher levels ofconsumption spending.

C= a+ bY



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marginal propensity to consume (MPC)- That fraction of a change inincome that is consumed, or spent.

marginal propensity to consume slope of consumption functionC

Y

aggregate saving (S)- The part of aggregate income that is notconsumed.

S Y C

The triple equal sign means that this equation is an identity, or somethingthat is always true by definition.

Identity- Something that is always true.



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When aggregate consumption is plotted along a straight line,C= a+ bY, an increase in income results in an increase inconsumption equal to:a. b.b. btimes Y.

c. atimes Y.d. a+ b.



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When aggregate consumption is plotted along a straight line,C= a+ bY, an increase in income results in an increase inconsumption equal to:a. b.b. btimes Y.c. atimes Y.d. a+ b.



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marginal propensity to save (MPS)- That fraction of a change in incomethat is saved.

MPC+ MPS 1

Because the MPC and the MPSare important concepts, it may help toreview their definitions.

The marginal propensity to consume (MPC) is the fraction of an increasein income that is consumed (or the fraction of a decrease in income thatcomes out of consumption).

The marginal propensity to save (MPS) is the fraction of an increase in

income that is saved (or the fraction of a decrease in income that comesout of saving).



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The consumption function shows the

relationship between desired

spending and the level of income.

Ca = autonomous consumption, does

not depend on the level of income.

by= the part of consumption that is

dependent on income:

b = marginal propensity to consume(MPC), or the fraction of additional

income that is spent.

y = level of income in the economy.

The Consumption Function

C = Ca + by


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Changes in the Consumption Function

An increase in autonomous

consumption from C0a to C1a

shifts up the entire

consumption function.

An increase in the MPC from b to b

increases the slope of the consumption

function.


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Changes in the Consumption Function

Factors that cause autonomous consumption to change

are:

Increases in consumer wealth.

Nobel Laureate Franco Modigliani found that consumer

wealth, or the value of stocks, bonds, and consumer

durables held by the public, will lead to increases in

autonomous consumption.

Increases in consumer confidence.

Changes in consumer confidence affect consumer

spending.


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The Aggregate ConsumptionFunction Derived from the EquationC= 100 + .75Y

In this simple consumptionfunction, consumption is 100at an income of zero.As income rises, so doesconsumption.For every 100 increase inincome, consumption rises by75.

The slope of the line is .75.

AggregateIncome, Y

AggregateConsumption, C

0 100

80 160

100 175

200 250

400 400

600 550

800 700

1,000 850



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Deriving the Saving Function from theConsumption Function

Because S Y C, it is easy to derivethe saving function from theconsumption function.A 45 line drawn from the origin can beused as a convenient tool to compareconsumption and income graphically.At Y= 200, consumption is 250.The 45 line shows us that consumptionis larger than income by 50.

Thus, S Y C= 50.At Y= 800, consumption is less thanincome by 100.Thus, S= 100 when Y= 800.

Y

AGGREGATEINCOME

C

AGGREGATECONSUMPTION

= S

AGGREGATESAVING

0 100 -100

80 160 -80

100 175 -75

200 250 -50

400 400 0

600 550 50

800 700 100

1,000 850 150



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Fill in the blanks. Where the consumption function is belowthe 45

line, consumption is ________ than income, andsaving is ________.a. more; positiveb. more; negativec. less; positive

d. less; negative



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Fill in the blanks. Where the consumption function is below

the 45

line, consumption is ________ than income, andsaving is ________.a. more; positiveb. more; negativec. less; positived. less; negative



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The assumption that consumption depends only on income is obviously

a simplification.

In practice, the decisions of households on how much to consume in agiven period are also affected by their wealth, by the interest rate, and bytheir expectations of the future.

Households with higher wealth are likely to spend more, other thingsbeing equal, than households with less wealth.

Lower interest rates are likely to stimulate spending.

If households are optimistic and expect to do better in the future,

they may spend more at present than if they think the future will bebleak.

Other Determinants of Consumption


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Planned Investment (I) versus Actual Investment

planned investment (I) Those additions to capital stock andinventory that are planned by firms.

actual investment The actual amount of investment that takesplace; it includes items such as unplanned changes in inventories.

A firms inventory is the stock of goods that it has awaiting sale.

If a firm overestimates how much it will sell in a period, it will end up withmore in inventory than it planned to have.

We will use I to refer to planned investment, not necessarily actualinvestment.


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Planned Investment Schedule

Planned investment

spending is a negativefunction of the interest rate.An increase in the interestrate from 3 percent to 6percent reduces plannedinvestment from I0 to I1.

Planned Investment and the Interest Rate (r)

Increasing the interest rate, ceter is par ibu s, is likely to reduce the level of

planned investment spending. When the interest rate falls, it becomesless costly to borrow and more investment projects are likely to beundertaken.


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The decision of a firm on how much to invest depends on, among otherthings, its expectation of future sales.

The optimism or pessimism of entrepreneurs about the future course ofthe economy can have an important effect on current planned investment.Keynes used the phrase animal spir i ts to describe the feelings ofentrepreneurs.

For now, we will assume that planned investment simply depends on theinterest rate.

Other Determinants of Planned Investment


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Equilibrium Output and the Consumption Function

Equilibrium outputis

determined where the C+ Iline

intersects the 45E line. At that

level of output, y*, desired

spending equals output.


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Equilibrium- Occurs when there is no tendency for change.In the macroeconomic goods market, equilibrium occurs when planned

aggregate expenditure is equal to aggregate output.

planned aggregate expenditure (AE)- The total amount the economyplans to spend in a given period. Equal to consumption plus plannedinvestment:

AE C+ I.

Because AE is, by definition, C + I, equilibrium can also be written:

Equilibrium: Y = C + I

Y > C+ Iaggregate output > planned aggregate expenditure

C+ I > Yplanned aggregate expenditure > aggregate output

The Determination of Equilibrium Output (Income)


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Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium. TheFigures in Column 2 Are Based on the Equation C= 100 + .75Y.

(1) (2) (3) (4) (5) (6)

Aggregate

Output(Income) (Y)

AggregateConsumption (C)

PlannedInvestment (I)

PlannedAggregate

Expenditure (AE)C+ I

UnplannedInventory

ChangeY

(C+ I)Equilibrium?

(Y= AE?)

100 175 25 200 100 No

200 250 25 275 75 No

400 400 25 425 25 No

500 475 25 500 0 Yes

600 550 25 575 + 25 No

800 700 25 725 + 75 No

1,000 850 25 875 + 125 No


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Equilibrium Aggregate Output

Equilibrium occurs whenplanned aggregateexpenditure and aggregateoutput are equal.Planned aggregateexpenditure is the sum of

consumption spending andplanned investmentspending.

The Determination of Equilibrium Output (Income)

The planned aggregateexpenditure function crosses

the 45 line at a single point,where Y = 500. (The point atwhich the two lines cross issometimes called theKeynesian cross.)


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The adjustment process will continue as long as output (income) is belowplanned aggregate expenditure.

If firms react to unplanned inventory reductions by increasing output, aneconomy with planned spending greater than output will adjust toequilibrium, with Yhigher than before.

If planned spending is less than output, there will be unplanned increasesin inventories. In this case, firms will respond by reducing output. Asoutput falls, income falls, consumption falls, and so on, until equilibriumis restored, with Ylower than before.

As the Figure shows, at any level of output above Y = 500, such as Y =

800, output will fall until it reaches equilibrium at Y = 500, and at any levelof output below Y = 500, such as Y = 200, output will rise until it reachesequilibrium at Y = 500.

Adjustment to Equilibrium


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Refer to the figure -1 below. When aggregate output equals $800billion, which of the following happens?

a. Unplanned inventory is rising, and output will tend to rise.b. Unplanned inventory is rising, and output will tend to fall.c. Unplanned inventory is falling, and output will tend to rise.d. Unplanned inventory is falling, and output will tend to fall.


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Refer to the figure -1 below. When aggregate output equals $800billion, which of the following happens?

a. Unplanned inventory is rising, and output will tend to rise.b. Unplanned inventory is rising, and output will tend to fall.c. Unplanned inventory is falling, and output will tend to rise.d. Unplanned inventory is falling, and output will tend to fall.


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There is only one value of Y for which this statement is true, and we can

find it by rearranging terms:

Let us find the equilibrium level of output (income)algebraically.

The equilibrium level of output is 500, as shown in Table 8.1 and Figure8.6.


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Savings and Investment

Savings equals output minus consumption.

CyS

Output is determined by demand, C+I, or

ICy

Subtracting consumption from both sides of the

equation results in:

ICy The left side shows thaty Cequals savings, S,

therefore:

IS


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Savings and Investment

Saving and Investment are equal at all levels of income as

they are derived from an identity.

However, savings and investment are in equilibrium at the

Equilibrium level of income.

The level of savings in the economy is not fixed, and how it

changes depends on the real GDP.

However, saving and Investment are in equilibrium only at

the equilibrium level of income as there are no

unwanted inventory accumulation or depletion.

The savings function is the relationship between the level

of income and the level of savings.

The fraction that the consumer saves is determined by his

or her marginal propensity to save (MPS).


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Because aggregate income must be saved or spent, by definition, Y C+S, which is an identity. The equilibrium condition is Y= C+ I, but this isnot an identity because it does not hold when we are out of equilibrium.

By substituting C+ Sfor Y in the equilibrium condition, we can write:

C+ S= C+ I

Because we can subtract Cfrom both sides of this equation, we are leftwith:

S= I

Thus, only when planned investment equals saving will there beequilibrium.

The Saving/Investment Approach to Equilibrium

The S= I Approach toEquilibrium

Aggregate output is

equal to plannedaggregate expenditureonly when saving equalsplanned investment (S=I).Saving and planned

investment are equal at Y= 500.


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Alternate Characterisation of Equilibrium Income

It depicts the income whereplanned expenditure and incomeare equal.

It depicts the income level wheresaving and investment are not onlyequal but also in equilibrium.

It also depicts the income whereactual investment is equal toplanned investment.


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Government Spending and Taxation

Both the level of government spending and the level

of taxation, through their influence on the demandfor goods and services, affect the level of GDP in

the short run.

Using taxes and spending to influence the level of

GDP in the short run is known as Keynesian fiscal

policy.

Government purchases of goods and services are a

component of total spending:

Planned expenditures including government = C + I + G


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Government Spending and Taxation

An increase in government

spending leads to an increase

in output.

An increase in taxes leads to a

decrease in output.

Multiplier for government

spending = 1/(1 MPC)

Tax multiplier

= MPC/(1 MPC)


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multiplier The ratio of the change in the equilibrium level of output to achange in some exogenous variable.

exogenous variable A variable that is assumed not to depend on the

state of the economy-that is, it does not change when the economychanges.

The Multiplier

The size of the multiplier depends on the slope of the planned aggregateexpenditure line. The steeper the slope of this line, the greater the change

in output for a given change in investment.


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Understanding the Multiplier

When investment increases by )Ifrom

I0 to I1, equilibrium output

increases by )yfromy0 to y1.

The change in output ()y) is greater

than the change in investment ()I).

Multiplier = 1/(1 MPC)

The Multiplier as Seen in the


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The Multiplier as Seen in thePlanned Aggregate ExpenditureDiagram

At point A , the economyis in equilibrium at Y=

500.When I increases by 25,planned aggregateexpenditure is initiallygreater than aggregateoutput.As output rises inresponse, additionalconsumption isgenerated, pushingequilibrium output up by amultiple of the initialincrease in I.

The new equilibrium isfound at point B, where Y= 600.Equilibrium output hasincreased by 100 (600 -500), or four t imestheamount of the increase in

planned investment.


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Refer to the figure below. In this example, the size of themultiplier equals:a. 1.33

b. 25c. 4d. 100.


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Refer to the figure below. In this example, the size of themultiplier equals:a. 1.33

b. 25c. 4d. 100.


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MPSS

Y

MPSI

Y

Because Smust be equal to Ifor equilibrium to be restored, we cansubstitute Ifor Sand solve:

Therefore, Y IMPS

1

, or

Recall that the marginal propensity to save (MPS) is the fraction of a

change in income that is saved. It is defined as the change in S(S)over the change in income (Y):

The Multiplier Equation

MPS

1multiplier

MPC1

1multiplier

It follows that


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In our simple economy (Y= C+ I), when investment rises,equilibrium income will change by:

a.

b.

c.

d.

S

Y

1

MPS

SI

Y

1I

MPS


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In our simple economy (Y= C+ I), when investment rises,equilibrium income will change by:

a.

b.

c.

d.

S

Y

1

MPS

SI

Y

1I

MPS

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Macro Session 10